Update: The beneficial conversion feature accounting model has been eliminated. Here’s a summary.
A beneficial conversion feature arises when the conversion price of a convertible instrument is below the per share fair value of the underlying stock into which it is convertible. The conversion price is ‘in the money’ and the holder realizes a benefit to the extent of the price difference. The issuer of the convertible instrument realizes a cost based on the theory that the intrinsic value of the price difference (i.e., the price difference times the number of shares received upon conversion) represents an additional financing cost. And, yes, this applies to both public and private companies alike.
On the surface this appears very straight forward…compare the conversion price to the stock price, multiply the difference times the number of shares and get on with life. But, this is GAAP and there are complexities and rules to address the complexities. So, we’ll try to give to clarity to this little corner of GAAP.
An important point to make before going in further is that there is much analysis that takes place before addressing a beneficial conversion feature (BCF). One must first rule out application the embedded derivative accounting. Derivative accounting is complex to say the least. The equity-linked transaction analysis tool on this site will hopefully make the analysis much easier for you. If you have not been through the analysis first, stop. You are potentially wasting time and effort looking into BCF accounting when derivative accounting is quite possibly the appropriate guidance.
Assuming you have ruled out derivative accounting, the place to start is the actual computation of the BCF amount. In a simple structure, the BCF intrinsic value is the calculation above, the number of shares times the positive difference between the fair value of the stock on the date of issuance and the contractual conversion price. But that’s where the simplicity ends. The additional issues that arise relate to the ‘effective’ conversion price when there are other instruments issued simultaneously with the convertible instrument, when the instrument is not immediately convertible, when there are contingencies, among others.
Let’s start with the concept of an ‘effective’ conversion price. You’ll probably recall that when multiple instruments are issued in a single transaction, the proceeds must be allocated to each instrument based on relative fair value. Fine. In the case of a convertible note issued with detachable warrants, for example, you compute the fair value of the warrant (usually a Black-Scholes option pricing model exercise) and allocate the lesser of that amount and the proceeds of the transaction to the warrant. The residual, if anything is left, is allocated to the convertible debt. Now take the amount allocated to the debt and divide by the number of shares into which the debt is convertible. That is you per share carrying value. If that number is less than the conversion price, then the ACTUAL effective conversion price for accounting purposes is the lower per share carrying value. The theory here is that regardless of the contractual conversion price, the actual investment in the convertible debt is lower and the real economic benefit is the difference between the fair value of the stock and the actual investment amount, in this case the proceeds allocated to the convertible debt. If the conversion price is lower than the share price on the date of issuance and there are no other instruments issued with the note, so that there is no allocation of proceeds preceding the BCF allocation, then the BCF is determined by reference to the contractual conversion price. However, It is often the case that the contractual conversion price has no accounting impact other than to determine the number of shares into which the convertible instrument is convertible. Once that determination is made, all accounting is performed by reference to the effective conversion price.
EXAMPLE #1 – Convertible Debt (Simple Case)
Here are some numbers to illustrate this:
Proceeds from issuance – $1,000,000
Conversion price – $10.00 per share
Shares issuable upon conversion – 100,000
Fair value of the warrants upon issuance – $250,000
FV of the entities stock at issuance – $12.00 per share
Carrying value of the convertible debt = Proceeds minus FV of the warrant or $1,000,000 minus $250,000 = $750,000. The amount allocable to the warrants is recorded as additional paid-in capital with an offsetting amount recorded as a discount on the debt. The discount is amortized using the interest method over the term of the debt. If the debt is payable on demand from inception, the discount is amortized to interest expense in full on the date of issuance.
Following allocation of the proceeds to the warrant, the per share carrying value of the convertible debt is $7.50 ($750,000 divided by 100,000 shares). The intrinsic value of the BCF is $450,000, which is simply 100,000 shares times the FV of the stock ($12.00) minus the effective conversion price ($7.50). The BCF amount in this example is recorded as paid-in capital with an offsetting amount recorded as an additional discount on the convertible note so that the carrying value of the note is now $300,000 ($1,000,000 minus $250,000 warrant value minus $450,000 BCF value). The debt discount attributable to the BCF is amortized over period from issuance to the date that the debt becomes convertible using the interest method. If the debt is immediately convertible, the discounted is amortized to interest expense in full immediately.
I have uploaded an Excel files with example calculations for debt. I used the basic model from the interest method example, so the numbers differ from the example above. I used Excel’s Goal Seek function to compute the effective rates needed to amortize the discounts to zero.
EXAMPLE #2 – Convertible Preferred Stock (Simple Case)
Assume the same facts as above but the convertible instrument is convertible preferred stock, not convertible debt. The primary differences in the accounting relate to the classification of the entries. Assuming the convertible preferred stock is classified in equity, the proceeds allocable to the warrant would be recorded as additional paid-in capital, with an offsetting debit applied to the convertible preferred stock. Likewise, the proceeds allocable to the BCF would be recorded as paid-in capital with an offsetting debit to convertible preferred stock. Assuming the preferred stock is not redeemable, the ‘discount’ attributable to the warrants has no further accounting effect (note the difference from the debt discount above…there is no maturity date on the preferred stock therefore there is no amortization). The discount attributable to the BCF, however, is amortized as a deemed dividend over the period from issuance to the date the convertible preferred stock becomes convertible. Thus, in the case of convertible preferred stock that is classified in equity, all accounting takes places within the equity section.
The above examples represent the most simple BCF cases. Before going into more complex issues, let’s cover two more quick examples:
EXAMPLE #3 – Convertible Note (Amounts Allocable to Warrants and BCF Exceed Total Proceeds)
Let’s assume the same facts as in Example #1, except the FV of the warrant is determined to be $500,000. In this situation, the effective conversion price of the convertible debt is only $5.00 ($1,000,000 proceeds minus $500,000 allocable to the warrants divided by 100,000 shares) resulting in a BCF of $700,000 ($12.00 stock price minus $5.00 effective conversion price times 100,000 shares). Since the allocation of proceeds to the warrant comes first, the warrant is recorded at its full value of $500,000 with an offsetting debit to debt discount. The BCF amount, however, is limited to the amount of remaining proceeds…$500,000. So upon issuance the carrying value of the debt is zero since all proceeds are allocated first to the warrant then to the BCF to the extent there are proceeds remaining to allocate. Conceptually, this simple means that the debt can not be recorded at less than zero since that would, in effect, reflect the debt as a asset. Even GAAP is not that crazy.
There’s an example calculation of debt issued with warrants in the Excel file.
One final comment…while there are almost always issuance costs associated with transactions involving convertible instruments that result in a BCF, all issuance costs are ignored for purposes of these calculations. Cash and non-cash issuance costs are accounted for separately and apart from the allocation of proceeds. However, if the non-cash issuance costs are paid in the form of convertible instruments, the convertible instruments issued are subject to the same accounting guidance as those sold to investors after first applying the guidance of ASC 505-50 (Stock-Based Compensation Issued to Nonemployees). Therefore, after applying ASC 505-50, the convertible instruments should be analyzed under applicable GAAP in the same manner as those sold to investors, including the embedded derivative guidance of ASC 815.
In all of the above examples, the issuance date is the date for measuring the BCF amount. This is not always the case. If a firm commitment is reached prior to the issuance date of the instrument, that date, the commitment date, is the date that should be used for measurement purposes. If there are any provisions that permit either party to rescind the agreement, such as a due diligence period or changes in the issuers operations or financial position, then the commitment date is either the date that those provision expire (i.e., the date that the contract goes firm) or the issuance date, whichever is earlier.
If the convertible instrument provides for a multiple-step discount, the BCF intrinsic value should be calculated based upon the most beneficial conversion price to the holder.
INSTRUMENT PAID IN-KIND
A convertible instrument whose interest or dividends is paid with the same such convertible instrument as the original and such in-kind payments are not discretionary (see ASC 470-20-30-7 for the conditions for in-kind payment to be not discretionary), the commitment date for the in-kind payments is the same as the commitment date for the original instrument.